California Supreme Court Confirms Intangible Assets Are Not Subject to Property Tax
On August 12, 2013, the California Supreme Court issued its decision in Elk Hills Power, LLC v. Board of Equalization, 57 Cal. 4th 593 (2013), holding that the State Board of Equalization (“BOE”) could not include the value of intangible assets and rights in the value of the taxable property. More specifically, intangible Emission Reduction Credits (“ERCs”) could not be assessed.
The taxpayer, Elk Hills Power, LLC (“Elk Hills”), applied for a permit to construct and operate a power plant in 1999. Because the San Joaquin Valley Unified Air Pollution Control District requires new pollution sources to purchase ERCs to offset future emissions before it will issue an “authority to construct” document, Elk Hills purchased five ERCs at an approximate cost of $11 million to offset the plant’s projected emissions and pollution.
The BOE used the cost approach and the income approach to calculate the unitary value of the plant. In applying the cost approach, the BOE added the estimated cost of replacing the ERCs. And, in applying the income approach, the BOE chose not to deduct the value of the ERCs from the overall value of the plant.
Elk Hills challenged the BOE’s valuation, arguing that the ERCs were intangible assets, which are exempt from property taxation under California law. The BOE, on the other hand, argued that it was permitted to “assume the presence” of the intangible ERCs when valuing the taxable power plant because the ERCs were necessary to put the power plant to beneficial or productive use. The BOE equated “assuming the presence” of the ERCs to including some or all of the value of the ERCs in the power plant’s unit value. As a result, according to the BOE, the intangible assets were not exempt from property taxation when they were necessary to put taxable property to beneficial or productive use. On summary judgment, the trial court found for the BOE. The California Court of Appeals affirmed.
Elk Hills petitioned for review by the California Supreme Court, arguing that section 212 of the California Revenue and Taxation Code prohibits the taxation of all intangible assets (with certain exceptions), and that subsection (d) of Section 110 (which provides that intangible assets shall not enhance or be reflected in the value of taxable property) trumps subsection (e) (which provides that taxable property may be valued by assuming the presence of the intangible assets necessary to put the property to productive use).
After reviewing the legislative history of all three statutory provisions and the relevant case law regarding the property tax treatment of intangible assets, the Court concluded that the provisions should be read in harmony. The Court also made four observations relating to the statutory provisions. First, the value of intangible assets, other than intangible assets specifically enumerated in the California Constitution, cannot be taxed directly or subsumed in the value of taxable property. Second, when valuing taxable property, assessors may assume the presence of intangible assets that are necessary to put the taxable property to beneficial and productive use. Third, assuming the presence of intangible assets permits the value of taxable property to be enhanced from salvage value to fair market value. Finally, when a unit value includes the direct valuation of an intangible asset or includes income attributable to enterprise value, those values must be accounted for and removed.
Based on these principles, the Supreme Court found that the BOE impermissibly included the fair market value of the ERCs within its unit value calculation under the replacement cost approach. The Court held that including the fair market value of an intangible asset within the unit whole amounts to the direct taxation of those assets. And, although the BOE was permitted to assume the presence of the ERCs in valuing Elk Hills’s taxable property, it impermissibly added the fair market value of the ERCs to the unit whole as part of its cost approach, and then failed to deduct that value prior to assessment. The Supreme Court, therefore, held that the Court of Appeal erred in upholding the BOE’s valuation of Elk Hills’s plant under the cost approach.
With regard to the income approach, the Court distinguished between intangible assets that have an “indirect” contribution to a business’s income stream versus such assets that have a “direct” contribution. The former permits taxable property to generate income when put to its beneficial or productive use, whereas the latter directly contributes to the going concern value of the business. Under California law, “indirect” intangible assets need not be deducted from an income stream analysis prior to taxation. But, income from intangible assets that contribute directly to a business’s income stream – such as goodwill, customer base, and favorable franchise terms – must be deducted. The Court concluded that the ERCs contributed indirectly to the business income stream because the ERCs enabled the subject property to function and produce income as a power plant. Accordingly, the BOE was not required to deduct the fair market value of the ERCs from the fair market value of the unit, and the Court of Appeal did not err in this regard.
Overall, Elk Hills is a taxpayer-friendly decision that supports the proposition that intangible assets may not be included in the unit value calculation under the replacement cost approach.
Please contact one of the Winston & Strawn SALT attorneys listed below if you have questions about how this case may affect your situation.
| Chicago (312) 558-5600 |
San Francisco (415) 591-1000 |
| Robert F. Denvir | Charles J. Moll III |
| Alan V. Lindquist | Troy M. Van Dongen |
| Jocelyn M. Wang |